Watch out for the new Dutch disease epidemic (2/2)

Bonjour,

Last week, we touched upon the new case of Dutch diseases around the world. While these countries are very dependent on oil and lack diversification, some tried to put some money aside for rainy days and built up financial reserves, constituted in a mixture of cash, debt instruments, stocks and other asset classes such as property.

Severe weather alert
The unexpected fact of the oil price fall has been that rainy day funds are now facing hurricanes: Saudi Arabia already spent 15% of its financial reserves in 2015 and is set to lose at least another 15% this year. Algeria, with an oil output of 1.7m bl a day will have swung from its usual $10bn trade surplus to a deficit of $20bn in 2016. The Kazakh sovereign wealth fund lost 16% over the past 18 months.

cartoon oil brains

One of the symptoms

How did we get there?
At this point we can introduce another economics concept called the Permanent Income Hypothesis. What the concept says is that one adapts its consumption not to one’s current level of income but rather to the expected future levels. So a lower income in one year will not change the spending pattern as long as the future level of income is still expected at the same level. Only a permanent large change in your income level would warrant a change of spending. Our oil producing countries are now only waking up to the fact that the expected future levels were too high.

At the country level, Brazil is finding that 90% of its spending cannot be curtailed given the guarantees it gave to pensioners and civil servants. The following chart shows that many oil producing countries are highly dependent on oil revenues, showing both symptoms of being a carrier of the Dutch disease and affected by the Permanent Income Hypothesis bias. The fact that many countries need an oil price around $100bl to balance their budget shows how fast their spending has tracked the higher oil prices. Oil started trading above $100 only in October 2007 against less than $10bbl in 1999, 8 years before.

_87777556_oil_breakeven_price_624v3

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Spend spend spend
The influx of dollars made these countries feel rich, enabling them to fund generous social programmes such as those in the Middle East, Eurasia or Latin America. Maybe one reason for spending can be found in the story of United Arab Emirates’ Sheikh Shakhbut ibn Sultan, 60 years ago.
Worried that oil revenues would turn the heads of his loyal subjects, he hid the cash received from oil sales under his bed.
Sadly, mice started to eat the dollars so he had to put the incoming notes into the bank. His comical penny-pinching (one had to obtain his royal permission to build a road or open a shop) led to his demise and in 1966, he was overthrown.
Understandably, no other ruler in the Middle-East or beyond were inspired by this experience.

Hillyard-Shakhbut_2830517c

Payments in cash, not Sheikhs

Let me now share the case of Venezuela. Under President Hugo Chavez, the country embarked on a massive spending through the Bolivarian missions. These missions built hospitals, houses, schools…

Very noble objectives which contributed to a fall in poverty rates from 49.4% in 1999 to 30.2% in 2006 according to the United Nations Economic Commission for Latin America and the Caribbean (ECLAC). However, the ECLAC showed a nearly 7% jump in poverty in 2013, from 25.4% in 2012 increasing to 32.1% in 2013. Local universities now put the poverty rate at 48.4% in 2015. it is now thought that only 10% of Venezuelans benefited from the missions’ money, out of which half were not poor in the first place. Some money could have been saved for rainy days.

chavez-oil-industry

Save save save
Today, there is no more money so profligacy is out of the question and local populations suffer. Algéria, a large oil and gas producer, already lost 25% of its reserves. The last period of low oil prices, between 1986 and 1995, led to a decade long recession and a civil war costing at least 60,000 lives. The country is only now reacting to the fall after thinking for one year that Saudi Arabia’s increased output was just bluff (!) Kazakhstan, best country in the world and third producer of potassium according to Borat, cut spending by 10% in 2015 by lowering the funding for winter sport events and delaying a subway in Almaty.

Some countries try to find original strategies to lessen the pain of austerity. Nigeria is banning imports of several categories of goods as to avoid stocking domestic inflation – inevitably, this creates shortages and substitution with lesser quality goods. Another tactic is more autoritarian: as shortages of many goods accelerated, Venezuela increasingly forced foreign companies to sell to the State their local subsidiaries. The total lack of management expertise led to the collapse of many consumer product supply chains. 80% of consumer products are now missing. You can hardly find toilet paper in shops in Caracas.

store-empty-shelves

Buy one get one free – if you can.

Looking ahead, for the countries affected by the Dutch disease, two solutions are possible: further spending cuts and/or selling assets. Spending cuts will endanger many regimes, which rested on generous handouts to silence the crowds. Firesale of assets are currently depressing global markets.
However, they are a great opportunity for other investors to get involved at better prices. For instance Saudi Arabia is considering opening the capital of Saudi Aramco, its oil producing company, to the public. This move is done in a position of weakness and will imply a low price during depressed business conditions to tempt investors.

Saudi Arabia’s loss can be our gain.

 

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